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1 The Costs of Separation: Friction between Company and Insolvency Law in the Single Market Carsten Gerner-Beuerle and Edmund Schuster LSE Law, Society and Economy Working Papers 6/2014 London School of Economics and Political Science Law Department This paper can be downloaded without charge from LSE Law, Society and Economy Working Papers at: and the Social Sciences Research Network electronic library at: Carsten Gerner-Beuerle and Edmund Schuster. Users may download and/or print one copy to facilitate their private study or for non-commercial research. Users may not engage in further distribution of this material or use it for any profit-making activities or any other form of commercial gain.

2 The Costs of Separation: Friction between Company and Insolvency Law in the Single Market Carsten Gerner-Beuerle * and Edmund Schuster ** Abstract: Corporate mobility and choice of law within the EU has dominated much of the academic writing in European company law over the last decades. What has not yet received much attention is the way in which national company law interacts with and depends on features of the national legal system outside of company law. In this article we explore this interaction and its relevance for coherent national regulatory systems. Using the regulatory framework for companies in the vicinity of insolvency as an example, we show how choice of company law can create both regulatory gaps and multiplication of legal requirements, as private international law rules are applied inconsistently across Europe. More importantly, however, we show that even consistent application of conflicts rules would fail to resolve these problems due to cross-doctrinal interdependence within any national legal system. We conclude that this is a design flaw in the way EU law deals with the increasingly international reach of corporations, and discuss possible paths for resolving or mitigating this issue. * Associate Professor, Law Department, London School of Economics and Political Science. ** Assistant Professor, Law Department, London School of Economics and Political Science. We are very grateful to John Armour, Jacco Bomhoff, Damian Chalmers, Brian Cheffins, Paul Davies, Eilis Ferran, David Kershaw, Jonathan Rickford, Wolf-Georg Ringe, Michael Schillig, and Richard Williams for valuable comments on an earlier draft. The usual disclaimers apply.

3 6/2014 A. INTRODUCTION The increase in corporate mobility in Europe and its impact on different aspects of company law has dominated much of the academic writing in European company law over the last two decades. 1 More recently, forum shopping and regulatory arbitrage in corporate insolvency have gained the attention of legal commentators, as an increasing number of companies have made use of foreign law rescue procedures they considered superior to what was on offer in their home legal systems. 2 However, debates about the effects of forum shopping have not fully appreciated the extent to which all national company law systems depend on aspects of adjacent areas of national law in order to achieve the desired regulatory outcomes. Company law, insolvency law, and to some extent other areas of law such as tort, administrative, and criminal law, interact with each other in complex ways to form integrated, coherent regulatory systems on the national level. These legal areas are functionally interdependent; they have developed in parallel over time as jurisdictions have made different choices of how to distribute regulatory tasks between them to address similar problems. The growing importance of corporate mobility has the potential to tear these coherent systems apart. Private international law rules, relying on a range of different connecting factors across different legal areas, are tasked with rebuilding this regulatory framework across borders, using legal building blocks of different origin, as companies establish connections with various jurisdictions. In doing so, they may, however, fail in three distinct ways. First, inconsistencies in the application of private international law rules may fail to create a complete regulatory 1 J Armour, Who Should Make Corporate Law? EC Legislation versus Regulatory Competition (2005) 58 Current Legal Problems 369; L Enriques and M Gelter, Regulatory Competition in European Company Law and Creditor Protection (2006) 7 European Business Organization Law Review 417; M Gelter, The Structure of Regulatory Competition in European Corporate Law (2005) 5 Journal of Corporate Law Studies 247; L Hornuf, Regulatory Competition in European Corporate and Capital Markets Law (Cambridge, Intersentia, 2012); C Timmermans, Impact of EU Law on International Company Law (2010) 18 European Review of Private Law 549; C Kirchner, RW Painter, and WA Kaal, Regulatory Competition in EU Corporate Law after Inspire Art: Unbundling Delaware s Product for Europe (2005) 2 European Company and Financial Law JA McCahery, Creditor Protection in a Cross-Border Context (2006) 7 European Business Organization Law Review 455; G McCormack, Jurisdictional Competition and Forum Shopping in Insolvency Proceedings (2009) 68 Cambridge Law Journal 169; H Eidenmüller, Free Choice in International Company Insolvency Law in Europe (2005) 6 European Business Organization Law Review 423; M Menjucq, Towards the End of the Real Seat Theory in Europe? in: M Tison and others (eds), Perspectives in Company Law and Financial Regulation - Essays in Honour of Eddy Wymeersch (Cambridge University Press, 2009), 124; WG Ringe, Forum Shopping under the EU Insolvency Regulation (2008) 9 European Business Organization Law Review 579; WG Ringe, Strategic Insolvency Migration and Community Law, in WG Ringe, L Gullifer, and P Théry (eds), Current Issues in European Financial and Insolvency Law (Oxford and Portland, Oregon, Hart, 2009), 71. The issue has also received much attention in the US under the rubric of forum shopping. Bankruptcy law is federal law, but it may be interpreted and applied differently by the courts, with potentially important implications for the outcome of the case, see LM LoPucki and WC Whitford, Venue Choice and Forum Shopping in the Bankruptcy Reorganization of Large, Publicly Held Companies (1991) Wisconsin Law Review 11. 2

4 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation framework. Certain rules or types of rules are disapplied in their entirety, resulting in regulatory gaps as some of the building blocks are not made available despite their existence in each of the national legal systems involved. Second, such inconsistencies may lead to the application of multiple and sometimes conflicting rules of the same type, thus rendering movement across frontiers more costly for companies. Third, and perhaps most importantly, completeness and lack of overlap are necessary, but not sufficient conditions for the coherence of a regulatory system. This last point goes beyond the problems created by conflicting or illcoordinated private international law rules. The efficacy of regulatory strategies depends on various legal and non-legal determinants, for example of a cultural or institutional nature. The nature and quality of these determinants will have played a pivotal role in how the distribution of regulatory tasks across different legal areas evolved over time, and legal systems will thus place different emphasis on the strategies at their disposal in regulating a common conflict. As the strategies are dissected and re-assembled across borders, the resulting regulatory framework may be complete in the sense that each inapplicable strategy of state A is replaced by a functional substitute of state B, but it may nevertheless fail to regulate the social conflict effectively. We observe this problem in various constellations, pointing to a fundamental design flaw in the way we deal with the increasingly international reach of domestic companies. This paper examines these problems by analysing an area where functional interdependence is especially pronounced and which, accordingly, seems wellsuited to highlight the practical relevance of the problems. We focus on the regulatory framework in relation to companies in the vicinity of insolvency and show how conflict of law rules and the territorial reach of administrative and criminal mechanisms give rise to substantial frictions in cross-border situations. We explore how these frictions create legal uncertainty and result in incoherent regulatory solutions, and we investigate the impact this may have on the efficient functioning of debt markets. The paper proceeds as follows. Section B will provide an overview of the legal framework for corporate mobility in Europe and the theoretical justification for mutual recognition of foreign-incorporated companies. In Section C, we will examine a number of legal strategies used in Europe to address the economic problems that arise in relation to companies in the vicinity of insolvency and analyse their international scope of application. Section D will focus on how corporate mobility and conflict of law rules may result in the application of incoherent, incomplete, and often inefficient rules to companies making use of their Treaty freedoms. Section E contains a number of possible solutions to the problems identified in Section D as well as our tentative conclusions. 3

5 6/2014 B. CORPORATE MOBILITY, MUTUAL RECOGNITION, AND REGULATORY ARBITRAGE 1. CORPORATE MOBILITY IN EUROPE As we will explain in more detail below, the problems addressed in this paper are for the most part direct consequences of the exercise by companies of the freedom of establishment enshrined in the Treaty, and the resulting concurrent application of different national rules across a number of legal areas. Before analysing these problems, it thus seems useful to briefly review the regulatory framework governing corporate mobility in the EU. Corporate mobility has rightly been described as the very essence of the internal market 3 as far as company law is concerned, and it clearly lies at the heart of European company law. The way corporate mobility has developed in Europe goes hand-in-hand with choice of law: by granting corporations the right to engage in cross-border business operations be it through branches or otherwise the Member States have undoubtedly accepted an obligation to tolerate the application and operation of foreign legal concepts within their national economies. The drafters of the Treaty were of course aware of the possible problems this intrusion of foreign companies into the territory of the different Member States could create. To resolve these issues particularly the question of when a company formed under the law of one Member State would have to be recognised 4 the Treaty envisaged a multilateral convention among the Member States. 5 Although the Member States agreed on the text of such a convention in 1968, 6 it was never ratified. In 2007, the drafters of the Lisbon Treaty apparently felt that such a convention was no longer necessary, and Article 293 TEC has now been repealed. 7 The perceived redundancy of the multilateral convention envisaged by Article 293 TEC can easily be traced back to developments in the ECJ s jurisprudence over the last decade or so. In a number of landmark decisions the Court clarified 3 KJ Hopt, The European Company Law Action Plan: An Introduction in: KJ Hopt and K Geens (eds), The European Company Law Action Plan Revisited (Leuven, Leuven University Press 2010), We use the term recognition to refer to a situation where the host Member State s legal system (i) treats the company in question as a legal entity, thereby accepting the legal status granted under the law of its formation, and (ii) where it accepts that the core arrangements of internal governance are also to be determined under that law. 5 See Article 293 TEC (ex Article 220 EEC) stated that Member States shall, in so far as necessary, engage in negotiations with each other with a view to ensuring for the benefit of their nationals [ ] the mutual recognition of companies within the meaning of [what is now Art 54(2) TFEU], the maintenance of their legal personality in cases where the registered office is transferred from one country to another, and the possibility for companies subject to the municipal law of different Member States to form mergers. 6 See Convention on the Mutual Recognition of Companies and Bodies Corporate (signed on 29 February 1968), Bulletin of the European Communities Supplement No See J Rickford, Current Developments in European Law on the Restructuring of Companies: An Introduction (2004) 15 European Business Law Review 1225, See Treaty of Lisbon (2007), OJ C 306, , Article 2 (280). 4

6 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation the most important issues regarding company recognition. It overwhelmingly did so in favour of corporate mobility. While in its Daily Mail decision 8 the Court still seemed to attach significance to the fact that no convention had been concluded between Member States to address problems of corporate mobility, 9 this was no longer seen as relevant by the Court in subsequent cases. Beginning with Centros, 10 the Court has developed what can be described as essentially a mutual recognition approach for EU-incorporated companies, based directly on Articles 49 and 54 TFEU. In Überseering 11 the Court expressly clarified that the exercise of the freedom of establishment does indeed not depend on any additional agreement among Member States, and in particular that the Treaty in envisaging a convention did not create a reserved area for national legislation outside the Court s scrutiny. 12 Thus, effectively, the Court ruled that the Treaty contains a very broad mandate to tolerate companies formed under foreign law operating within their territory, and in doing so made clear that restrictive national conflicts of law rules will have to be disapplied unless justified. Importantly, the Court also made clear that this tolerance towards foreignincorporated entities (i.e. the obligation to recognise them as such) does not depend in any way on them carrying out any business activity in their countries of formation. 13 The Court held that choice of the company law that an incorporator considers to be the most advantageous is inherent in the exercise, in a single market, of the freedom of establishment, and that this holds true even where businesses adopt a particular structure for the sole reason of becoming subject to their preferred law. 14 It is widely acknowledged that the line of cases started by Centros opened the door to choice of law and thus regulatory arbitrage within the EU. 15 Rather than treating pure choice of law (i.e. situations where choice of law is the sole reason for 8 Case 81/87 The Queen v HM Treasury and Commissioners for Inland Revenue, ex p Daily Mail and General Trust plc [1988] ECR See ibid, para Note, however, that the Court in Daily Mail only mentioned the convention in relation to the retention of legal personality in the event of transfer of the registered office of companies from one country to another. 10 Case C-212/97 Centros Ltd v Erhvervs- og Selskabsstyrelsen [1999] ECR I-1459 at para Case C-208/00 Überseering BV v Nordic Construction Company Baumanagement GmbH (NCC) [2002] I Ibid para 54. See e.g. WF Ebke, The European Conflict-of-Corporate-Laws Revolution: Überseering, Inspire Art and Beyond (2004) 38 International Lawyer 813, ; WG Ringe, The European Company Statute in the Context of Freedom of Establishment (2007) 7 Journal of Corporate Law Studies 185, 194; C Gerner-Beuerle and M Schillig, The Mysteries of Freedom of Establishment After Cartesio (2010) 59 International and Comparative Law Quarterly 303; C Gerner-Beuerle, United in Diversity: Maximum versus Minimum Harmonization in EU Securities Regulation (2012) 7 Capital Markets Law Journal 317, By country of incorporation we refer to the jurisdiction under whose laws the company acquired its status (i.e. under whose laws it was formed ). 14 See Case C-167/01 Kamer van Koophandel en Fabrieken voor Amsterdam v Inspire Art Ltd [2003] ECR I at para 121, and Centros (supra n 10), at para 27, where the Court clarifies that such motives cannot, in itself, constitute an abuse of the right of establishment. 15 See e.g. Rickford, supra n 6, 1248; Armour, supra n 1; W Bratton, J McCahery, and E Vermeulen, How Does Corporate Mobility Affect Lawmaking? A Comparative Analysis (2009) 54 American Journal of Comparative Law 347; Menjucq, supra n 2, 124; J Armour and WG Ringe, European Company Law : Renaissance and Crisis (2011) 48 Common Market Law Review

7 6/2014 relying on the Treaty freedoms) as an abuse, the Court made clear that the freedom of establishment is (at least also) meant to permit exactly that. 16 Since a significant and growing number of Member States do not require a factual link between their territory and companies formed under its laws, 17 entrepreneurs from across Europe can now choose from among these laws, no matter where the majority (or indeed all) of its business activities will take place. In other words, Member State cannot require the use of corporations formed under its law for business activities in its territory, as long as some Member States allow the formation of letter-box companies. 18 Until relatively recently, however, the resulting choice of law was, in practice, primarily of interest for small, newly formed start-up firms, since a number of obstacles made re-incorporation difficult for established firms. 19 Due to their structure, 20 newly established companies do not usually have a particular demand for highly sophisticated company law solutions, and consequently choice of law was mainly driven by factors such as minimum capital requirements, basic formation costs, and the speediness of the incorporation process. 21 This does not mean, however, that the Centros line of cases has been irrelevant for larger, established undertakings: it significantly increased the flexibility of corporate groups with regard to their legal structure, as it also protected the status of local subsidiaries irrespective of the location of their effective management, 22 and moreover had implications for corporate taxation. The importance of the Establishment chapter for larger, established businesses is likely to further increase as a consequence of developments in both the case law and EU secondary law. First, the Court of Justice has now made it clear that the freedom of establishment also confers on established firms a right to change the law that governs its internal 16 See Rickford, ibid at Apart from a registered office, which is little more than a postal address. The term registered office is thus often being used as being synonymous to the incorporation seat in the sense that it highlights the jurisdiction under whose laws the company has been formed. See e.g. European Commission, Consultation on the cross-border transfers of registered offices of companies (2013), available at 18 I.e. companies with no business activity and no permanent establishment in the jurisdiction under whose law they are formed, such that the only connection with their incorporation jurisdiction consists of their business address (registered office). See e.g. M Garcia-Riestra, The Transfer of Seat of the European Company v Free Establishment Case-Law (2004) 15 European Business Law Review 1295, 1300; Rickford, supra n See e.g. Armour, supra n 1; Bratton and others, supra n Especially shareholder structure; most start-ups will have only few shareholders. 21 See e.g. W-G Ringe, Corporate Mobility in the European Union a Flash in the Pan? An Empirical Study on the Success of Lawmaking and Regulatory Competition (2013) 10 European Company and Financial Law Review 230; Bratton and others (supra n 15), 348; Armour, supra n 1, 385; L Enriques, EC Company Law Directives and Regulations: How Trivial Are They? (2006) 27 University of Pennsylvania Journal of International Economic Law I.e. as long as the state of incorporation does not restrict the choice of the corporate headquarters; see Case C-210/06 Cartesio Oktató és Szolgáltató bt. [2008] ECR I

8 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation organisation by either merging with companies incorporated abroad 23 or by reincorporating in another jurisdiction 24 with legal continuity. Moreover, both the European Company Statute 25 and the Cross-Border Merger Directive 26 increase the ease with which companies can subject themselves to another Member State s law, albeit in the former case only if the process coincides with a physical relocation of the company s headquarters. 27 Recently, the European Commission has revived the 14 th Directive 28 on the reincorporation of existing companies a project it had abandoned in after the European Parliament requested that issue to be addressed by a Directive because it considered the case law on this matter to have left open too many questions. 30 Taken together, the developments described above are likely to profoundly change the European corporate landscape over the coming years. A number of pathways make choice of company law rules available to both entrepreneurs (incorporators) and established firms throughout the EU, which adds opportunities for regulatory arbitrage the ability to subject the same economic structure to one of a variety of different sets of legal rules, each with its benefits and costs, in order to reduce costs or increase profits by benefitting from the most (privately) advantageous regulatory treatment without changing the economic substance of the transaction. 31 It is not our aim to assess the costs and benefits of regulatory arbitrage in European company law. Much has been said about how regulatory arbitrage in company law may affect the European corporate landscape, the likelihood of the 23 C-411/03 SEVIC Sytems AG v Amtsgericht Neuwied [2005] ECR I While the Court made it clear in SEVIC that cross-border mergers fall under the Treaty freedoms and thus have to be made available to European firms irrespective of specific or harmonising legislation, many practical questions remained open, making this route unfeasible or impracticable for most established companies in the EU; see e.g. Hopt (supra n 4), a See Case C-210/06 Cartesio, n 22 above, at para ; Case C-378/10 VALE Építési kft [2012] ECR I-0000, decided See e.g. JL Hansen, The Vale Decision and the Court s Case Law on the Nationality of Companies (2013) 10 European Company and Financial Law Review. 25 Council Regulation (EC) No 2157/2001 of 8 October 2001 on the Statute for a European company (SE) OJ L 294/1. See e.g. H Eidenmüller, A Engert, and L Hornuf, Incorporating under European Law: The Societas Europaea as a Vehicle for Legal Arbitrage (2009) 10 European Business Organization Law Review Directive 2005/56/EC of the European Parliament and of the Council of 26 October 2005 on crossborder mergers of limited liability companies, OJ L 310/1. 27 See Article 8 of the SE Statute (supra n 25). For a discussion of this requirement see Ringe, supra n 12, who questions its compatibility with Article 49 TFEU (but see Case C-210/06 Cartesio, n 22 above). 28 See Pubic Consultation on the cross-border transfers of registered offices of companies, n 17 above. 29 On this see M Wyckaert and F Jenne, Corporate Mobility in K Geens and KJ Hopt (eds), The European Company Law Action Plan Revisited: Reassessment of the 2003 Priorities of the European Commission (Leuven, Leuven University Press 2011) 298; J Rickford, Free Movement of Capital and Protectionism after Volkswagen and Viking Line (2009) in M Tison and others (eds), supra n 2, at European Parliament resolution of 2 February 2012 with recommendations to the Commission on a 14th company law directive on the cross-border transfer of company seats, 2011/2046(INI). The resolution contains detailed instructions, essentially asking the Commission to replicate the mechanisms of the Cross-Border Merger Directive (supra n 26). 31 See for a general definition e.g. F Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage (1997) 22 Journal of Corporation Law 211, 227; V Fleischer, Regulatory Arbitrage (2010) 89 Texas Law Review 227,

9 6/2014 creation of a European Delaware, 32 the possible impact of regulatory arbitrage on Member States rule-making and regulatory competition, 33 as well as the relationship between capital and labour, 34 the costs and benefits of experimentation and specialisation by legislators, the ability of the law-maker to accommodate the idiosyncrasies of particular market participants, or the effect regulatory competition has on the quality of legal rules. Our aim is much more modest. Rather than questioning whether a system of company law choice has or will have positive or negative effects as such, we merely want to examine how the interaction of legal rules across different areas of law and across different jurisdictions may create problems where companies are permitted to choose the applicable (company) law. The problems we discuss here are likely to exist in a wide variety of circumstances, but the regulation of companies in the vicinity of insolvency seems to provide a particularly suitable showcase to draw attention to the legal issues at play. 2. MUTUAL RECOGNITION, HOME STATE CONTROL, AND HARMONISATION OF COMPANY LAWS Before delving into the different areas of law affecting a company in the vicinity of insolvency, we must examine the theoretical backdrop against which the Court has developed its interpretation of the freedom of establishment and its relationship with corporate mobility. Clearly the Centros-line of cases 35 allocates regulatory power between Member States; for the large (and ill-defined) area of company law, it does so in favour of the Member State initially granting legal status to a corporation, irrespective of economic realities i.e. largely ignoring the nature of the factual ties between a company s business and the national economies of the Member States. When analysing the implications of EU law for the private international law in this area, two issues are worth highlighting. First, company law constitutes the legal framework according to which most private economic activity is carried out in market economies, and there can thus be little doubt that a clear and predictable allocation of rule-making powers between different interested (i.e. affected) Member States is an important prerequisite for the functioning of the single market. Without an allocation of some sort companies operating across borders would be subject to multiple, potentially conflicting and perhaps unpredictable legal 32 E.g. Armour, supra n 1; L Enriques, EC Company Law and the Fears of a European Delaware (2004]) European Business Law Review 1259; S Lombardo, Regulatory Competition in Company Law in the European Union after Cartesio (2009) 10 European Business Organization Law Review 627; Bratton and others (supra n 15). 33 E.g. Bratton and others (supra n 15); A Johnston and P Syrpis, Regulatory Competition in European Company Law after Cartesio (2009) 34 European Law Review M Gelter, Tilting the Balance between Capital and Labor? The Effects of Regulatory Arbitrage in European Corporate Law on Employees (2010) 33 Fordham International Law Journal See text to n

10 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation obligations. But this does not necessarily assist us in answering which rule-making rule is likely to create the best outcomes, and there are of course various possible candidates. Second, a distinction has to be made between an allocation of rulemaking powers intended to merely avoid costly duplication of regulatory efforts on the one hand, and solutions which go further by designating one single Member State to decide all matters arising within a particular regulatory space on the other hand. These two issues are also (loosely) related to the familiar mutual recognition and home state control approaches. 36 The former approach, by aiming at avoidance of regulatory redundancies, focusses on preventing Member States from ignoring the regulatory framework an entity is subject to due to its connection with other Member States. The impact of such an approach to defining Member States regulatory competences is rather limited, as it would suggest that Member States are only prevented from enforcing unnecessary rules i.e. rules the aims of which have already been achieved by other means. In other words, a pure mutual recognition approach primarily mandates an appreciation of the relevant regulatory history before imposing legal requirements for (in our case) companies with cross-border operations. 37 Any such approach is of course based on a notion of equivalence between the different legal systems involved. A meaningful duplication can only exist where one presumes that the relevant jurisdictions are all able and willing to give effect to the rules in question, and only this equivalence justifies prioritising one jurisdiction over the other when defining the regulatory spaces occupied by different Member States. To be sure, this is not to say that all jurisdictions involved are necessarily equally well-suited to address the questions at issue. In fact, one would expect that the allocation of regulatory power will be informed by a notion of who the best-suited regulator would likely be in a given context, although views on this question are bound to differ across Member States. The point is, rather, that this approach prevents Member States from generally presuming the necessity to substitute or supplement foreign regulatory solutions with domestic ones. As such an approach aims only at preventing duplication of regulatory burdens, it ultimately depends on an acknowledgement that a particular legal problem or social conflict is in fact also being addressed by another Member State. Absent that, an (exclusive) allocation of regulatory powers cannot be explained by a desire to avoid double jeopardy. Take for example a rule requiring company directors to pay due regard to the environmental impact of the company s operations existing in one Member State. To the extent that no other interested Member State adopts rules of similar effect, even a wide outreach application of this rule would not lead to a duplication of the regulatory burden of companies subject to the rule. To be sure, the very question of whether or not a particular rule results in a relevant duplication of regulatory efforts will often be a 36 See KA Armstrong, Mutual Recognition in C Barnard and J Scott (eds), The Law of the Single Market: Unpacking the Premises (Oxford, Hart, 2002), 225, especially at See Armstrong (ibid at 234). 9

11 6/2014 controversial one. One may, for instance, take different views on whether the application of a duty of company directors to pay due regard to an undertaking s environmental impact in Member State A operates in much the same way as concurrently applicable stricter direct environmental protection laws in Member State B, or whether minimum capital requirements in Member State A and stricter distribution rules in Member State B create a double jeopardy -situation when applied cumulatively. Nevertheless, following the double jeopardy-logic would mean that it is the answer to this double jeopardy -question that determines the regulatory reach of the jurisdictions involved. Under the alternative approach pure home state control regulatory power would be directly and exclusively allocated between the interested Member States, e.g. in favour of the jurisdiction which has first granted market access 38 or, in the case of companies, the law of the Member State under which the company has initially been formed. Unlike the mutual recognition approach, true home state control or a competitive regulatory model 39 reaches beyond the problem of duplicity of regulatory compliance. Instead of only seeking to avoid a situation where EU nationals are burdened by multiple different regulatory requirements that all pursue a common policy goal, home state control also, in principle, covers situations where Member States disagree on these very policy goals, rather than just the best path to achieve them. Both approaches cannot be viewed in isolation from the harmonisation of laws, and particularly so in the area of company law. First, both approaches can operate as alternatives to the harmonisation of laws. 40 Rather than harmonising regulatory requirements, cross-border activity can be facilitated within a fairly diverse regulatory environment, provided that compliance with the legal requirements of one (i.e. the home state) system replaces the requirements to comply with similar rules of another (i.e. the host state) legal system. Second, the relevance of mutual recognition depends on equivalence and similarity of the relevant legal frameworks: Where legal systems differ too much, a strategy of the mutual recognition type would likely fail to lower the cost of cross-border activity simply because the home state requirements that have been complied with do not address the same issues as the rules of the host state legal order, which means that engaging in cross-border activity increases the regulatory burden, even if the additional rules do not duplicate the already existing requirements of the home jurisdiction, as can be seen in our example above. Thus, the approach we labelled mutual recognition is likely to be of little use in practice for facilitating crossborder economic activity unless a certain level of harmonisation of substantive laws (or at least close alignment of policy goals) exists. 41 The home state control- 38 See ibid at MP Maduro, We the Court: The European Court of Justice and the European Economic Constitution (Oxford, Hart, 1998) See Armstrong, supra n 36, ibid. 10

12 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation approach is linked even more intimately with the harmonisation of national laws, or more precisely with the equivalence of such laws. 42 By accepting the exclusive application of home rules in cross-border situations, the host state effectively signs away its ability to regulate economic activity within its borders, as it necessarily results in economic actors only complying with one set of rules, even where the parallel application of different sets of rules would not result in an unnecessary accumulation of regulatory requirements. Thus, host states and every Member State is of course also a host state in relation to some economic actors will typically accept a system of home state control only where the substantive rules across the different jurisdictions are similar enough, i.e. where the scope for regulatory arbitrage is diminished by the equivalence of the different sets of rules. 43 How can we best categorise the approach taken by the Court of Justice in relation to corporate mobility and choice of law? This question cannot yet be answered with certainty, and as will be shown below, Member States seem to take different views on it. Where exactly would the differences lie between a home state control and a mutual recognition model in the area of company law? Clearly, both approaches would result in the home state (i.e. the incorporation jurisdiction) retaining most of the regulatory power over company law, with limited scope for host state control a result we know to be right in practice based on the jurisprudence of the European Court. Viewed through the lens of a mutual recognition model, the allocation of regulatory power to the home state would follow from the fact that, naturally, both jurisdictions have to address the same types of problems and social conflicts, such that compliance with both jurisdictions legal requirements would necessarily involve a costly duplication of regulatory requirements. A pure home state approach would lead to the same result without the intermediate step of testing whether the two jurisdictions indeed address the same problems through their laws. However, where the host state addresses a policy area (say, environmental policy) at least in part through company law rules, 44 while the state of incorporation employs a different, non-company law technique (e.g. emission trading), what we call the mutual recognition model would suggest that the host state s power to regulate is unaffected: an outreach application of the domestic rules to all companies operating within its territory would not lead to a duplication of regulation. A home state control view, on the other hand, would suggest that the power to regulate company law as such is allocated to the home state, and that perceived gaps in that law such as the absence of environmental considerations in directors duties regulation is irrelevant. 42 It is of course the equivalence or similarity of laws that ultimately matters here, but equivalence will typically require harmonisation in most areas of the law. 43 See on the link between this and the concept of maximum harmonisation Gerner-Beuerle, supra n E.g. by defining directors duties with reference to environmental impact. 11

13 6/2014 None of the Centros-line cases 45 provides a clear answer as to the underlying model. Inspire Art 46 may be the most informative case in that it concerned a clear outreach-type statute: Dutch rules applicable to certain foreign-incorporated entities intruded into and interfered with the status-providing home state law (UK law), and the Court held this intrusion to be a (non-justifiable) restriction. However, in that case Dutch law purported to do so in order to protect creditors a concern undoubtedly shared by the UK company law legislator. Thus, the outcome of Inspire Art and the remaining Centros-line cases can be explained under both models here presented. Nevertheless, the Court s reasoning, as well as the absence of any meaningful examination of functional equivalence between home and host state rules in the case law, suggests that it indeed is a home state control model that the Court has developed. There is at least one important case in which the underlying model -question would be highly relevant: board-level employee participation. Except following a cross-border merger or an SE-formation, employee participation rules are currently applied on an incorporation basis only, and no significant attempt has been made to our knowledge by any Member State to apply its employee participation rules to foreign-incorporated companies. But what if, say, Germany adopted such a law, for instance mandating employee representatives on boards of foreign companies with significant (or exclusively) German operations? It is submitted that an assessment of such a (hypothetical) rule would differ depending on the underlying model, being permissible under a mutual recognition view, but in need of Gebhard-justification 47 under a home state control model. The latter outcome, arguably, seems more likely. It is also worth pointing out that both models are necessarily based on implicit presumptions of equivalence, 48 although these presumptions differ somewhat depending on the fundament one suspects beneath the Court s case law. Most obviously, a home state control approach must be based on the presumption that the Member State allocated with regulatory power in a particular area of law will be willing and able to create a legal framework that is, in general terms, acceptable to other Member States. But even a mutual recognition model must be predicated on the presumption of broad equivalence regarding the efficacy of the legal systems involved, which justifies that broad, indistinctly applicable host state measures duplicating home state requirements constitute a prima facie breach. 49 The implied 45 supra n supra n See Case C-55/94 Gebhard v Consiglio dell'ordine degli Avvocati e Procuratori di Milano [1995] ECR I-4165, which requires restrictions to be non-discriminatory, suitable to achieve an overriding public interest objective, proportionate, and not go beyond what is necessary to achieve the objective in question. 48 See on the link to mutual recognition, e.g., C Barnard, The Substantive Law of the EU : The Four Freedoms (Oxford University Press, 2nd edn, 2007) 111; see also A Rosas, Life after Dassonville and Cassis: Evolution but no Revolution in MP Maduro and L Azoulai (eds) The Past and Future of EU law: The Classics of EU Law Revisited on the 50th Anniversary of the Rome Treaty (Oxford, Hart, 2010), 433, See e.g. Centros (supra n 10). 12

14 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation presumptions of equivalence are of course an expression of the set of common principles across Member States, and perhaps ultimately an expectation that Member States have an interest in creating appropriate national company law systems that avoid externalities, which explains the high bar set by the Gebhard test. Company law is in some ways special : its rules are necessarily highly interlinked and interdependent, and they do not lend themselves easily to be selectively replaced by foreign law. In fact, the two competing conflict of laws approaches, the real seat and the incorporation doctrine, have in common that they both aim at leaving intact what is generally a coherent set of interwoven rules. 50 The incorporation doctrine achieves this, in principle, by applying the home state legal system in relation to most questions of company law, no matter how closely connected a company is to another jurisdiction. 51 The real seat doctrine, on the other hand, leaves intact the home state legal system i.e. accepts that the foreign company will be governed by home state law but does so only up to a certain point typically the point is where the centre of management and control is located in the jurisdiction applying the real seat doctrine. Where the intensity of connection with the real seat state exceeds this trigger, the real seat jurisdiction will then apply its entire company law to the foreign entity. In both cases, the combination of company laws and the relevant conflict of laws rules ensure that companies are subject to a coherent, compatible and typically well thought-through legal framework in relation to most aspects of their internal organisation, including their relationship with investors. The special status of company law, and the one law -result achieved by both of the traditional approaches to allocate rule-making powers across Member States in company law matters, may also support a home state control-approach view of the Court s case law. Problems do arise, however, whenever company law rules interact with other areas of law or with the institutional framework offered by a particular 50 The aim to agree on a private international law framework for companies which not only achieves consistent results across jurisdictions, but which also renders only one national law applicable to all aspects of a company s life has been an integral part of the international efforts in this field; see e.g. the ILA Draft Convention on Conflicts of Law relating to Companies, International Company Law Report (1958) 48 Int l L. Ass n Rep. Conf. 629, 645 (Art 3 and 4). This question has also been raised in the US, where corporate law is a matter of State regulation; the Supreme Court has emphasised the importance of a single law solution (see Edgar v. MITE Corp., 457 U.S. at 645: the internal affairs doctrine is a conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation s internal affairs matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders because otherwise a corporation could be faced with conflicting demands (emphases added)). Similarly, the Delaware Supreme Court in VantagePoint (VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005)) refused to apply a Californian law purporting to regulate the internal affairs of certain Delaware corporations; see C Allmendinger, Company Law in the European Union and the United States: A Comparative Analysis of the Impact of the EU Freedoms of Establishment and Capital and the U.S. Interstate Commerce Clause (2013) 4 William & Mary Business Law Review 67, 83. See also P Kindler, Internationales Handels- und Gesellschaftsrecht, in FJ Säckerand and R Rixecker (eds), Münchener Kommentar zum Bürgerlichen Gesetzbuch (Munich, CH Beck, 5th edn, 2010, Vol 11), at 321, emphasising the fact that functional interdependence of company law rules necessitates the applicability of one single law. 51 See on the two different theories e.g. Menjucq, supra n 2; Armour and Ringe, supra n

15 6/2014 jurisdiction. 52 This can be true throughout the life of a company, of course: capital maintenance rules may interact with accounting regulation; company law may implicitly or explicitly rely on the existence of notaries to afford protection to shareholders and third parties; the liability of company directors may depend on their status under the applicable labour law; the exercise of voting rights may be restrained by concepts of general civil law. Accordingly, the operation of company law may change once the company leaves its home jurisdiction at least to the extent that by doing so, it severs the connection between the company law it is subject to and the rules that interact and were meant to interact with it. One situation where inter-doctrinal interaction becomes particularly important, it is submitted, is where a company approaches insolvency. While, as we shall see, all Member States implement legal strategies to address the various problems connected to this stage of a company s life, the legal techniques used differ widely. More importantly, these legal strategies are located in areas of law the application of which depends on connecting factors different from what determines the application of the company law rules they interact with. C. FUNCTIONALITY AND INTERNATIONAL SCOPE OF CREDITOR PROTECTION LAW 1. LEGAL STRATEGIES TO PROTECT CREDITORS IN THE VICINITY OF INSOLVENCY As a company nears insolvency and the equity capital evaporates, perverse incentives are created for shareholders and directors alike. 53 Creditors, rather than shareholders are now rightly to be seen as residual claimants. 54 At this point, shareholders (and directors) have privately optimal risk-levels for the company s business operation that would render it inefficient to leave them in charge without regulatory intervention. 55 Virtually all legal systems have developed strategies to address this problem and to avoid inefficient risk-shifting in the vicinity, or upon occurrence, of insolvency. 52 This is of course the very problem discussed in relation to all legal transplants ; see infra Section D.2. The problem can even arise within a given jurisdiction; see e.g. E Rock and M Wachter, Dangerous Liaisons: Corporate Law, Trust Law, and Interdoctrinal Legal Transplants 96 Northwestern University Law Review See e.g. PL Davies, Directors Creditor-Regarding Duties in Respect of Trading Decisions Taken in the Vicinity of Insolvency (2006) 7 European Business Organization Law Review 301; H Eidenmüller, Trading in Times of Crisis: Formal Insolvency Proceedings, Workouts and the Incentives for Shareholders/Managers (2006) 7 European Business Organization Law Review 239; T Bachner, Wrongful Trading A New European Model for Creditor Protection? (2004) 5 European Business Organization Law Review Davies, ibid at See the detailed analysis by Eidenmüller, supra n

16 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation In the EU, the main strategies are: (1) a duty of the company directors to file for the opening of insolvency proceedings; (2) liability of the directors for wrongful trading, i.e. the continuation of trading even though there was no reasonable prospect that the company would avoid going into insolvent liquidation ; 56 (3) a change of directors fiduciary duties; and (4) the duty to call a general meeting and either recapitalise or liquidate the company. These strategies are supplemented by general principles of company law or civil and commercial law. The general duties of directors continue to apply in the vicinity of insolvency. For example, directors may be held liable for a breach of the duty of care by managing the company imprudently and thus causing or aggravating the company s insolvency. Some jurisdictions take recourse to tort law to hold directors responsible for a loss suffered by the creditors. Finally, in addition to civil liability, administrative and/or criminal sanctions apply to directors who fail to file for the opening of insolvency proceedings in violation of legal requirements or display other types of misconduct. An important administrative sanction is the disqualification of directors, which may be ordered by the bankruptcy court if the director has been convicted of a crime and, depending on the jurisdiction, if the director has materially violated legal obligations or is unfit to be concerned in the management of a company. 57 The following table gives an overview of the distribution of the four main strategies in the EU and, for purposes of comparison, the US. 58 Country Table 1. Legal strategies in the vicinity of insolvency Duty to file or wrongful trading Change of duties Convene or recapitalise Austria duty to file no convene GM Belgium duty to file no convene GM Bulgaria duty to file no recapitalise Croatia duty to file no convene GM Cyprus wrongful trading yes convene GM Czech Republic duty to file no recapitalise Denmark hybrid approach (both) 59 yes convene GM 56 UK Insolvency Act 1986, s 214(2)(b). 57 Irish Companies Act 1990, s. 160(2)(d); UK Company Directors Disqualification Act 1986, ss. 6(1), 8(2). 58 Adapted from C Gerner-Beuerle, P Paech, and EP Schuster, Study on Directors Duties and Liability (2013), available at Note that not all strategies apply equally to private limited companies. 15

17 Country Duty to file or wrongful trading Change of duties Convene or recapitalise Estonia duty to file yes recapitalise Finland duty to file no convene GM France duty to file no recapitalise Germany duty to file no convene GM Greece duty to file no convene GM Hungary duty to file yes convene GM Ireland wrongful trading yes convene GM Italy duty to file no recapitalise Latvia duty to file yes recapitalise Lithuania duty to file no recapitalise Luxembourg duty to file no recapitalise Malta duty to file yes convene GM Netherlands wrongful trading prohibition no convene GM Poland duty to file no convene GM Portugal duty to file no recapitalise Romania wrongful trading no convene GM Slovakia duty to file no convene GM Slovenia duty to file no convene GM Spain duty to file no recapitalise Sweden duty to file no recapitalise United Kingdom United States wrongful trading yes convene GM deepening insolvency 60 ambivalent 61 No duty to convene or 6/ Case law has established a rule similar to the UK wrongful trading prohibition. Directors who know (or should have known) that the company has no reasonable prospect of avoiding insolvency must minimise the potential losses to creditors or will be liable. In addition, a duty to file for insolvency also applies. 60 The tort of deepening insolvency goes back to Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) (applying Pennsylvania law). However, it is not recognised as a separate cause of action in Delaware and does not give rise to a duty to liquidate, see Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del Ch. 2006). Instead, deepening insolvency claims may be integrated into the general framework of directors duties, In re The Brown Schools, 386 B.R. 37, (Bankr. D. Del. 16

18 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation As is evident from Table 1, the majority of member states provide for a duty on the part of a company s directors to timely file for insolvency. Typically, this strategy is then buttressed by a consequential liability of directors for any depletion of the company s assets resulting from the delayed insolvency filing. In most Member States employing this strategy, this liability can only be enforced by the liquidator and thus results in a proportional satisfaction of all creditors claims. The second main strategy is very similar in nature. Instead of setting a legal requirement for the insolvency filing, a jurisdiction may require directors to cease trading at a particular point in time. The filing strategy is more widely spread. It is necessarily triggered by the insolvency of the company (however defined by national law), rather than merely a threat of insolvency. The wrongful trading strategy will sometimes be triggered only after the company has reached a state of formal balance sheet insolvency, 62 but may also be triggered before the company is formally insolvent, as it is based on an assessment of the company s financial prospects. Thus, directors of a formally insolvent company that has a realistic chance to trade its way out of its situation may be justified in continuing the business, while directors in a not-yet insolvent company may be obliged to cease its operations where the avoidance of a (future) insolvency seems highly unlikely. Of course, jurisdictions following the duty to file -strategy will also often allow the continuation of trading beyond the point where the company is balance-sheet insolvent, 63 but they will do so by adjusting the definition of the insolvency grounds, rather than by adjusting the duty to file itself. In addition, in some Member States the definition or the scope of directors duties changes as the company approaches insolvency, particularly by moving from a shareholder-centric towards a more creditor-regarding set of objectives, 64 or by changes in the general standard of care. 65 An additional regulatory strategy that at least indirectly addresses the problems posed by companies in the vicinity of insolvency is the so-called re-capitalise or liquidate rule. Throughout the EU, public companies are obliged to call a general meeting where the (cumulated) losses of a company exceed 50% of the subscribed capital. 66 While the Second Directive requires the calling of a general meeting in 2008). For a discussion see CW Frost, Corporate Governance in insolvency and Bankruptcy (San Francisco, LexisNexis, 2011), 3[4]. 61 Delaware courts initially allowed the directors to rely on the interests of the creditors as a shield in order to rebut a breach of duty claim brought by the shareholders, Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corporation, 1991 W.L (Del. Ch.). In recent decisions, the Delaware courts, however, emphasised that the content of the duties of directors and the constituencies to whom they are owed do not fundamentally change in the vicinity of insolvency. See, for example, North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. Supr. 2007) (holding that in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners. Ibid, 101). 62 See e.g. Davies, supra n 53, 311; Bachner, supra n See the comparison of German and English law by Bachner, supra n See e.g. Davies, supra n 53, at This seems to be the case in relation to Denmark. 66 See Art 17 of the Second Council Directive 77/91/EEC of 13 December 1976, OJ L 26/1. 17

19 6/2014 these circumstances, it does not actually require companies to take any specific action. In so far as Art 17 of the Second Directive only requires a meeting of the shareholders, the rule does not seem to follow a clear economic rationale. First, the reference to the subscribed capital is, in itself, not a meaningful triggering event. The registered share capital will not be a particularly useful reference point, as this figure says virtually nothing about the assets or capital needs of a company. 67 Second, even (or particularly) where the event of losses amounting to more than 50% of the registered share capital is a significant point in time in the company s life, it is at the very least questionable whether this is the right time to put shareholders in the driver s seat given the perverse incentives that exist at this point. 68 In fact, to the extent that this event coincides with the company becoming significantly undercapitalised, shareholders incentives are distorted, since limited liability will often mean that an increase in the company s risk profile also leads to an increase in the value of their shares. While a majority of the Member States have implemented Art 17 of the Second Directive as a mere duty to call a meeting, some go beyond this minimum requirement. These Member States require companies to choose, upon a loss of half of their subscribed share capital, between either re-capitalising the company or winding down its operations and liquidating the company. The effect of the recapitalise or liquidate rule on near-insolvency trading is twofold. First, it aims at making it less likely for companies to trade in a state of capital depletion, at least where the nominal share capital is indeed a significant figure. Second, duty-related enforcement mechanisms are directly linked to this strategy, as failure to ensure that appropriate capital measures are taken at this very early stage typically leads to the liability of the directors. In fact, it may well be the case that it is the relative ease with which non-compliance with this rule can be proven, as compared to e.g. incompetent management or foreseeability of insolvency, which makes this strategy attractive despite the arbitrary nature of its trigger. 2. EU PRIVATE INTERNATIONAL LAW FRAMEWORK The principle of home state control, as we understand it here, attempts to avoid friction between legal systems and the imposition of double burdens on market participants that engage in cross-border economic activity by allocating comprehensive regulatory authority to one Member State, the home state. However, whether a social conflict is comprehensively regulated by one legal system depends not only on the existence of a rule, usually stemming from European law, that performs this allocative function unambiguously and to the exclusion of regulatory action by other Member States, but also on the coherence 67 See J Rickford, Reforming Capital: Report of the Interdisciplinary Group on Capital Maintenance (2004) 15 European Business Law Review 919; J Armour, Legal Capital: an Outdated Concept? (2006) 7 European Business Organization Law Review See Davies, supra n

20 Carsten Gerner-Beuerle and Edmund Schuster The Costs of Separation of the home state s legal system. In domestic situations, a legal system is necessarily coherent in that the solution to the social conflict will be derived from the body of rules constituting the legal system. In cross-border situations, on the other hand, the home state s private international law determines whether, and if yes, which parts of the home state s substantive law are applicable to the case at hand. Thus, the goal of home state control may be undermined by a dissection of regulatory authority at the second stage of the investigation, with potentially detrimental consequences for mobility within the single market. The conflict rules that determine the law applicable to European companies with cross-border operations are partly harmonised and contained in a number of EU regulations, and partly derive from national law. The most likely sources of the legal strategies discussed above that are employed to address disputes in the vicinity of insolvency are a country s insolvency law, company law, and tort law. We will examine the conflict rules in these areas in turn in order to sketch the private international law framework that governs vicinity of insolvency situations and assess the extent to which it leads, in appropriate situations, to a dissection of regulatory authority. Insolvency law The rules on jurisdiction for opening insolvency proceedings, recognition of judgments delivered on the basis of such proceedings, and the applicable law have been unified by the EU Insolvency Regulation. 69 The main connecting factor, both for jurisdiction and applicable law, is the centre of a debtor s main interest (COMI). The courts of the Member State in whose territory the COMI is located have international jurisdiction to open insolvency proceedings. 70 COMI is a rather ambiguous criterion that has given rise to a substantial body of case law and received much attention in the academic literature. 71 It is not necessary to review the debate in this article; a brief description of the concept shall suffice. According to the Regulation, the centre of main interest corresponds to the place where the debtor conducts the administration of his interests on a regular basis, 72 which has been interpreted by national courts as referring to the place where the head office functions of the company are performed. 73 In the case of a legal person, COMI is presumed to be at the place where the person s registered office is located. 74 The presumption can be rebutted if factors which are both objective and ascertainable by third parties enable it to be established that an actual situation exists which is 69 Council regulation (EC) No 1346/2000 of 29 May 2000 on insolvency proceedings [2000] OJ L160/1. 70 Insolvency Regulation, art 3(1). 71 For a detailed discussion with references see G Moss, IF Fletcher, and S Isaacs (eds), The EC Regulation on Insolvency Proceedings (Oxford University Press, 2nd edn, 2009), , The leading decision of the Court of Justice is Case C-341/04 Eurofood IFSC Ltd. [2006] ECR I Insolvency Regulation, Recital 13. The Proposal for a Regulation of the European Parliament and of the Council amending Council Regulation (EC) No 1346/2000 on insolvency proceedings, COM(2012) 744 final, moves the definition of the COMI from the recitals to the main text, see art 3(1), as amended. 73 For a discussion of the case law see Moss et al, supra n 71, Insolvency Regulation, art 3(1). 19

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